Why Financial Statements don’t work for digital companies?

Kapso 9th August, 2018

We have recently heard of IPO’s of companies like Uber, Twitter etc. these are digital companies and despite of showing losses of US $ 97 million, twitter commanded a valuation of US $24 billion on its IPO date. And other example we can take is Facebook paid a whooping amount of US $19 billion for WhatsApp when it had no revenue no profit. In contrast, industrial giant GE’s stock price has declined by 44% over the last year, as news emerged about its first losses in last 50 years.

Why do investors react negatively to financial statement losses for an industrial firm but disregard such losses for a digital firm?

When we analyze financial statements of a industrial firm we can find the assets as property, plant, equipment, machinery and other things and these expenses are capitalized and expensed as deprecation over their useful life so the expenses matches the revenue of the current year.

But when we take a digital firm like Facebook it doesn’t have much tangible assets and all the assets are basically intangible assets such as network effect, customers, technology etc. and all these items are a part of expense for that year whether they may have a useful life of more than 1 year. This is the main reason why technology firms reports a huge loss in initial years because they invest so much in building these intangible assets all these investments are a part of expenses for that particular year.It’s important to note that companies like professional services firms are also built on intangible assets like human capital. But accounting challenges for modern, digital companies are more severe, as they have increasing returns to scale on their idea-based platforms. For example, Google can service billions more clients with the same office just by adding to its server capacity. But for an audit firm to drastically increase clients, it would likely need more manpower and office space. Furthermore, costs of services for professional services firms, mainly wages, are matched to current revenues. So their income statements accurately reflect surplus created in that period, similar to industrial companies. But for digital companies, the bulk of the cost of building an idea-based platform is reported as an expense in its initial years, when they have little revenue. In later years, when they actually earn revenues on an established platform, they have fewer expenses to report. In both phases, the calculation of earnings does not reflect the true costs of revenues.

So now we have a fair idea why financial statements do not provide a fair picture for the digital companies, what digital companies can do is they can Any significant, value-relevant development must be immediately disclosed rather than waiting for the annual report. Companies can provide detailed information on intangible investments made by the company – even if that information is not vetted by the auditors – by reporting these investments in three categories: customer relationship and marketing, information technology and databases, and talent acquisition and training a investor can have a fair idea of company and can make decisions based on that.

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